Professional Documents
Culture Documents
2014
Professor Fernando Diz
What do we need to
understand and learn to be
successful value investors?
Need to understand
We need to have a clear idea of what
investing means to us.
Need to understand
We need to understand how
businesses create value (wealth).
How do we view businesses?
Need to understand
We need to understand how value
(wealth) created by corporations can
be extracted by holders of securities.
Need to understand
We need to understand how to
appraise the value created by
businesses.
Need to understand
We need to understand if there are
relationships between security prices
and corporate values (if any) (i.e.
understand what market efficiency
depends on, and whether efficiency is
prevalent or not and why)
HOW do we get to a
definition?
We all have some idea of what the differences
between investing and speculating are.
You will be surprised to realize how misleading
those ideas can be.
We shall explore a few of the misconceptions and
by thinking about them, we shall refine our own
definition.
Arbitrage on margin
Example:
Borrow $155,000 for a year at 5%.
Use the proceeds of the loan to buy 100 ounces
of gold in the cash market for $1,550/oz.
Simultaneously enter into a forward agreement to
deliver gold in a year and get paid $1750/oz.
Arbitrage on margin
In one year, you deliver 100oz of gold and get
paid $175,000.
With the proceeds, you pay back the loan for
$155,000 plus the 5% interest for a total
payment of $162,750.
You make a profit of $12,250 without any risk
of loss. Really?
Arbitrage on margin
This is an example where a profit is guaranteed on a
transaction that has no risk of loss and was done
entirely with borrowed money.
Moreover, it is done as a short term transaction.
Would you consider this a speculation?
NO.
5. Standards of Safety
The concept of safety can only be of any use if it
is based on something more tangible than the
psychology of the purchaser.
Safety must be assured or at least strongly
indicated by the application of definite and well
established safety standards.
Let us look at what we mean next:
5. Standards of Safety
What are the standards of safety that we use?
Standards of safety related to the issuer (company),
i.e. strong financial position, shareholder friendly
managements, etc. These are used to insure that the
business is safe.
Standards of safety related to the issue (terms of the
issue), i.e. a secured loan is over-secured with
pledged assets of high quality. These have to do with
the substantive characteristics of securities.
Price of the issue.
Summary
There is nothing inherent to a security that makes it
either an investment or a speculation.
Whether a security is purchased outright or on margin
has nothing to do with whether the operation is an
investment or a speculation.
The holding period, whether long or short, does not
necessarily discriminates between an investment or a
speculation.
Whether the security is purchased for income or profit
may not be related to whether it is an investment or a
speculation.
Safety of principal in the form of very low or nonexistent investment risk is a factor in determining
whether the commitment is an investment or a
speculation.
Definition of Investment
An investment operation is one which, upon
thorough analysis, that can be justified on both
quantitative and qualitative grounds, promises
safety of principal and a satisfactory return.
Operations that do not meet these criteria are
speculative.
Thorough analysis
Means the study of the facts qualitative and
quantitative- in light of:
Established standards of safety
For issuer:(reserves, capital adequacy, strong financial
position, claim paying ability, quality of resources).
For issue: price of a security, terms, rights given, covenants.
Satisfactory return
A broader expression than adequate income since it
allows for capital appreciation.
It refers to total return
Example
In 1934, GE special preferred, paid 6% interest
on a $10 par and was callable on any dividend
date at $11. Calendar quarters, dividend
payment on the first week after the end of
quarter.
On December 1934, the preferred sold at $12
.
Is buying this preferred in December 1934 an
investment or a speculation and why?
Example continued
An investment operation is one which, upon
thorough analysis that can be justified on both
quantitative and qualitative grounds, promises safety
of principal and a satisfactory return. Operations that
do not meet these criteria are speculative.
Is buying the preferred a safe choice?
Example continued
Is the issuer safe?
Yes
Example continued
As far as the safety of principal is concerned,
the buyer at $12 was speculating to the
extent of $1 or 10% of his principal.
He was betting that the issue would not be
called for years to come.
In fact the issue was called at $11 on April 5,
1935.
Example 2
After the call announcement was made in
January 1935, the preferred promptly traded
down to $11.
The actual call took place in April 1935, i.e.
three months hence.
Margin borrowing costs were 2% per year.
Investment opportunity for margin-buying.
Example 2 continued
Borrow $110,000 at 2% per year.
Buy 10,000 shares of preferred at $11 per share.
Collect one dividend of 6%/4= 1.5% or
0.015*100,000= $1,500 in April 1935.
Pay 2%/4 = 0.5% on $110,000 or $550
Pocket sure profit of $950 in three months.